Can Informal Finance Substitute for Formal Finance?

A couple of years ago, at a meeting of World Bank financial sector experts, one of the Vice Presidents at the time challenged me by saying, “You always talk about the importance of the financial sector for development, and emphasize we need to prioritize financial sector reforms, but just look at China. It is doing very well without a well functioning financial system.”

This struck a chord. I had also recently seen an academic paper making more or less the same point, that China is one of the fastest-growing economies in the world despite weaknesses in its formal banking system. Of course there is a large literature on finance which shows that development of formal financial institutions is associated with faster growth and better resource allocation. It has also long been recognized that informal financial systems play a complementary role in developing countries, typically consisting of small, unsecured, short-term loans restricted to rural areas, agricultural contracts, households, individuals, or small entrepreneurial ventures.

There is even a direct parallel in developed countries called angel finance, where high-net-worth individuals—“angel investors”—provide initial funding to young firms with modest capital needs until they are able to receive more formal venture capital financing. But informal finance substituting for formal finance? Conventional wisdom has always been that this is not likely since informal monitoring and enforcement mechanisms are generally ill equipped for scaling up and meeting the needs of the higher end of the market.

But more and more frequently, China was being brought up as an example to support the contention that the reform of formal financial systems is a low priority. The fast growth of Chinese private sector firms was seen as evidence that what supports China’s growth is alternative financing and governance mechanisms. Some even thought this was enough to ignore financial systems and move straight on to other development priorities in designing reform programs. We had to do more research to understand better…

My co-authors Max, Meghana and I started doing this by using the World Bank’s detailed, firm-level enterprise survey data on 2,400 Chinese firms. We wanted to investigate which of two views is consistent with the operation of the informal financial sector in China:

Is the informal financial sector associated with high growth and profit reinvestment, and does it serve as a substitute for the formal financial system?

Or does the informal sector primarily serve the lower end of the market?

We find that in China the use of bank financing by private firms is comparable to that in other developing countries, but the breakdown of nonbank financing sources shows greater differences (see table below). Unlike firms in other countries, Chinese firms in our sample do rely on a large informal sector and alternative financing channels, which could well be the large underground lending in China.

Nevertheless we see that it is financing from formal bank sources that is positively associated with firm growth and reinvestment. Contrary to earlier findings, fund-raising from informal channels is not associated with faster firm growth. Interestingly, while we find that the majority of firms that receive bank loans grow faster as a result, there is a subpopulation of firms that do not. These are the firms that report it was government’s help that allowed them to obtain the bank loan in the first place. These firms do not show faster growth, higher reinvestment, or greater productivity, unlike firms getting bank loans without government help. Of course these results do not make China an exception to the growth and finance literature. Far from it, they are also very consistent with previous work showing the disadvantages of government owned banks.

Overall, the conclusion is quite clear: even in fast-growing economies like China where the formal financial system serves only a small part of the private sector because of a poorly developed financial and legal system, external finance from the formal financial system is associated with faster growth and higher profit reinvestment rates for the firms that receive it. We find no evidence that alternative financing channels are associated with higher growth. So reputation- and relationship-based informal financing and governance mechanisms are likely to play a limited role in supporting the growth of private sector firms and unlikely to substitute for formal mechanisms. These results underline – once again – not only the importance of formal finance in the development process, but the urgency in carrying out financial sector reforms where financial systems are poorly developed.

For further reading, see Meghana Ayyagari, Asli Demirgüç-Kunt, and Vojislav Maksimovic, “Formal versus Informal Finance: Evidence from China.” Review of Financial Studies (Forthcoming). In the meantime, here is the Policy Research Working Paper version.